PWG Issues Report on Money Market Fund Reform Options - Financial Services

The President's Working Group on Financial Markets ("PWG") on October 21, 2010 released its long-awaited report on "Money Market Fund Reform Options" (the "Report").¹ The Report states that the large scale redemptions of MMF shares in September 2008 underscored the vulnerability of the financial system to systemic risk because the cash needs of MMFs seeking to meet redemptions exacerbated strains in short-term funding markets, which in turn threatened the broader economy. The Report acknowledges that the SEC's adoption of amendments to the regulatory structure governing MMFs earlier this year was an important "first-step" in making MMFs more resilient and less risky.² However, the Report recommends that more be done to address systemic risks and the structural vulnerabilities of MMFs to "runs." To that end, the Report presents the following possible reform options for consideration by the Financial Stability Oversight Council ("FSOC") that was recently established by the Dodd-Frank Wall Street Reform and Consumer Protection Act:³

floating net asset values;
privately sponsored emergency liquidity vehicles;
mandatory redemptions in-kind;
insurance for MMFs;
a two-tier system providing enhanced protections for stable net asset value ("NAV") MMFs;
a two-tier system reserving stable NAV MMFs solely for retail investors;
regulating stable NAV MMFs as special purpose banks; and
enhancing constraints on unregulated MMF substitutes.

Although the Report discusses various reform options for the FSOC to consider, it does not recommend any particular reform. Many had expected the Report to propose that MMFs adopt floating NAVs—a proposal strongly resisted by the mutual fund industry and issuers of short-term debt, among others.⁴ Not only does the Report acknowledge several concerns with the floating NAV option, but the Report also speaks favorably about an industry-supported plan to provide MMFs with access to a privately sponsored emergency liquidity vehicle.

Floating Net Asset Values

The Report suggests that requiring MMFs to adopt floating NAVs could lessen investor perception that MMFs are "risk-free" vehicles (since experiencing losses would become more routine), thereby reducing the likelihood of runs in the event of a loss. The Report also states that, because share prices for redemption requests in a floating NAV fund would be established after the requests are received, losses to the fund would be realized by all shareholders, rather than only by those who remain in the fund. The Report states that this sharing of losses could reduce incentives to redeem shares when the risk of capital loss is rumored.

The Report acknowledges that eliminating the ability of MMFs to maintain a stable NAV would be "a dramatic change for a nearly $3 trillion asset-management sector that has been built around the stable $1 share price." The Report addresses the perceived disadvantages of a floating NAV requirement at some length. For example, the Report states that requiring floating NAVs could reduce demand for MMFs or cause investors to shift their assets to other investment vehicles, such as offshore MMFs or enhanced cash funds. The Report observes that because MMFs are significant providers of credit, such a reduction in assets could cause an abrupt and significant tightening of short-term debt markets. Moreover, since MMF substitutes are both subject to less regulation and just as susceptible to runs, the Report points out that imposing a floating NAV requirement may merely transfer the systemic risk to different and less transparent investment vehicles.

The Report also highlights problems and risks with the implementation of any floating NAV requirement. For example, MMF investors could preemptively redeem shares prior to the implementation of a floating NAV requirement to avoid potential losses. Additionally, the Report notes that because funds will no longer be able to use amortized cost to maintain a stable NAV, the benefits perceived by investment advisers of complying with Rule 2a-7 under the Investment Company Act of 1940 (as amended, "ICA") may be lost or become vague, causing risk management practices, as required by Rule 2a-7, to possibly deteriorate.⁵

Private Emergency Liquidity Vehicles

In 2008, when MMFs were experiencing heavy capital outflows, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (as created by the Federal Reserve Board, "AMLF") helped funds to meet redemptions by extending credit to banks and bank holding companies to finance their purchases of asset-backed commercial paper from MMFs. Noting the success of this program, the Report states that a liquidity protection system is necessary to strengthen MMFs against the risk of similar crises in the future. The Report notes further that a private liquidity vehicle, as opposed to a publicly-supported system like the AMLF, could have several benefits, including:

increased ability of MMFs to withstand large redemptions without selling illiquid securities at a discount;
efficiency gains experienced through risk pooling;
increased flexibility in managing liquidity risks; and
internalization of the costs of liquidity protection.

Members of the mutual fund industry generally support the creation of a private liquidity system.⁶ However, the Report stresses that implementing such a system will be challenging and must be considered carefully in order not to distort incentives and favor certain market participants over others. The Report raises the following concerns:

whether voluntary participation in a liquidity facility would be more effective than mandatory participation;
whether the liquidity system has the capacity to functionally meet MMFs' needs in times of crisis;
whether there is a potential for conflicts of interest when liquidity is in short supply; and
how to curtail the "moral hazard" problem as advisers feel less pressure to personally maintain liquidity in their funds.

Mandatory Redemptions in Kind

The Report observes that large redemptions by one investor of a MMF tend to force other investors in the fund to bear the liquidity costs when the fund is forced to sell assets at an inopportune time. The Report states that requiring payments on redemptions to be paid in kind under such circumstances would shift liquidity costs to the redeeming investor. However, the Report observes that implementing an in-kind redemption program could be operationally problematic. For example, the Report notes that institutional investors may circumvent the program by structuring investments to "hover" below the in-kind limitations, and that providing a redeeming investor with a pro rata share of securities may not be possible if the fund's portfolio securities are not freely transferable.

Insurance for MMFs

The Report states that the success of the Treasury's Temporary Guarantee Program for Money Market Mutual Funds⁷ illustrates that insurance for shareholders can be useful in mitigating the risk of large capital outflows.⁸ The Report suggests that the implementation of an insurance program could help mitigate systemic risk, although it notes that the following issues could arise depending on the specific design of the insurance program:

Public, Private, or Hybrid Form of Insurance. Private insurers have historically encountered problems pricing financial events, and public insurance would require additional government oversight and administration.
Voluntary or Mandatory Participation. Although mandatory insurance would increase investor confidence, it would necessitate additional government intervention and administration.
Increased Moral Hazard Risks. The incentives for fund advisers to manage risk will shift to the insurers.
Pricing Challenges. If insurers do not accurately price securities relative to the risks associated with a MMF portfolio, moral hazard could increase. Also, under-priced insurance could lead to disturbing outflows from bank deposits, while over-priced insurance could reduce the relative investment appeal of MMFs.

Two-Tier Systems for MMFs

Two-Tier System with Enhanced Protections for Stable NAV MMFs

The Report suggests that, rather than requiring all MMFs to use a floating NAV, a two-tier regulatory program that allows both stable NAV funds and floating NAV funds might accommodate more investors with varying risk appetites, while still addressing systemic risk concerns. Under such a program, stable NAV MMFs would be subject to enhanced protections, such as insurance or private liquidity, while floating NAV funds would be subject to less stringent restrictions and would be allowed to bear greater credit and liquidity risks.

The Report states that, in contrast to other options, a two-tier system would mitigate the risk that MMF investors will shift investments to MMF substitutes, while gaining some of the benefits associated with a floating NAV system. The Report notes further that during times of crisis, investors may shift assets from floating NAV MMFs to stable value MMFs, which would be less disruptive to the credit markets. However, the Report states that a two-tier system contemplates investors who are sophisticated enough to understand the different risk profiles of the two tiers, and that if this assumption is incorrect, investors may still exit funds during a crisis, possibly impacting credit markets.

Two-Tier System with Stable NAV MMFs Reserved for Retail Investors

The Report suggests that another approach to mitigating risk would be to restrict investments in each type of MMF according to investor type—retail or institutional. The Report indicates that, because of their stake in the market and ability to monitor market conditions, institutional investors create greater risk of runs than do retail investors. As such, a two-tier system based on investor type could serve to protect retail funds and their customers from the effects of runs instigated by redemptions by institutional investors. The Report notes, however, that such a system would require a working definition of "institutional investor," and suggests that any regulatory structure would have to address the risk that investors will circumvent the threshold established to distinguish between retail and institutional investors.

The Report acknowledges that prohibiting institutional investments in stable NAV funds may have unintended consequences, such as providing a catalyst for investors to shift assets to MMF substitutes offshore or for institutional investors to shift assets to other investment vehicles, possibly disrupting short-term funding.

Regulating Stable NAV MMFs as Special Purpose Banks

Noting that MMFs and bank deposits are both subject to the risk of runs and are ostensibly conservative investments, the Report suggests that requiring stable NAV MMFs to reorganize as Special Purpose Banks ("SPBs") could be advantageous. The Report explains that, if stable value NAV MMFs were designated as SPBs, such vehicles would be subject to banking oversight and regulation, such as reserve requirements, capital buffers, liquidity backstops, and insurance coverage.

However, the Report states that, although transforming stable value MMFs into SPBs is conceptually simple, there are several practical barriers and hurdles that add complexity to this reform option. The Report acknowledges that this option would require vast regulatory and legislative changes—not merely interagency coordination— and that significant considerations would include:

whether MMFs, which are not typically capital intensive, would be able to raise substantial equity to meet SPB capital requirements;
the probability of increased government liabilities, as deposit insurance requirements increase; and
whether the level of deposit insurance would protect institutional investors such that they are less likely to redeem their fund investments during times of crisis.

Enhanced Constraints on Unregulated MMF Substitutes

The Report acknowledges that many of the options discussed in the Report, while reducing the systemic risks to MMFs, could have the unintended consequence of causing investors to shift away from MMFs to unregulated investment vehicles. The Report notes that such MMF substitutes are often just as vulnerable to runs as registered MMFs, and that, to the extent investors move their assets to such funds, systemic risks will likely increase. Accordingly, the Report recommends that MMF reform include reform of MMF substitutes, and suggests specific regulatory changes, including:

prohibiting unregistered investment vehicles from maintaining stable NAVs;
amending Sections 3(c)(1) and 3(c)(7) of the ICA to make these registration exceptions from the definition of "investment company" unavailable to funds that seek to maintain stable NAVs; and
instituting banking and state insurance restrictions on funds and pools that seek to maintain a stable NAV but are exempt from registration under the ICA.

Conclusion

Recent events have shown that MMFs can be susceptible to runs. The SEC's new rules and rule amendments are designed to make MMFs more resilient and less risky. However, the PWG's Report emphasizes that the recent changes to the regulatory structure governing MMFs address only some of the features that make MMFs susceptible to runs. The Report concludes that more should be done to address systemic risks presented by MMFs and the structural vulnerabilities of MMFs to runs. The reform options presented by the Report will be submitted for consideration by the FSOC in the year ahead.

Footnotes

1. See "Report of the President's Working Group on Financial Markets: Money Market Fund Reform Options," available at http://treas.gov/press/releases/docs/10.21%20PWG%20Report%20Final.pdf. In 2009, the Department of the Treasury ("Treasury") had proposed that the PWG prepare a report on fundamental changes needed to address systemic risk and to reduce the susceptibility of money market mutual funds ("MMFs") to runs. See "Financial Regulatory Reform: A New Foundation," available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.

2. For a summary discussing the SEC's changes to the regulation of MMFs, see "Amendments to the Regulatory Structure Governing Money Market Funds," DechertOnPoint (March 2010), available at http://www.dechert.com/library/FS_4_03-10_SEC_Adopts_Money_Market_Fund_Rule_Amendments.pdf.

3. To assist the FSOC with its analysis of these options, the SEC will solicit public comments on the Report.

4. See "Group of Thirty, Financial Reform: A Framework for Financial Stability" (2009), available at http://www.group30.org/pubs/reformreport.pdf . This publication criticizes MMFs, specifically expressing disapproval of the concept of amortized cost pricing. The report was a product of a study done by the G30, which at the time was led by Paul Volcker, now the chairman of the President's Economic Recovery Advisory Board and an advisor to the PWG.

5. Reacting to the Report's discussion of floating NAVs as a possible measure to address the structural vulnerabilities of MMFs to runs, the U.S. Chamber of Commerce issued a press release shortly after the Report was made publicly available, warning against instituting a floating NAV requirement or similar requirement that could harm MMFs. See "U.S. Chamber Warns Against Moves That Would Harm Money Market Funds: Removing Stable Pricing Would Harm Businesses, Investors, and Recovery" (Oct. 21, 2010), available at http://www.uschamber.com/press/releases/2010/october/us-chamber-warns-againstmoves-would-harm-money-market-funds.

6. See, e.g.,"ICI Weighs Creating Liquidity Facility for Money Funds" (March 9, 2010), available at http://www.ignites.com/c/55387/10562/weighs_creating_liquidity_facility_money_funds; see also "Statement with SEC Investment Advisory Committee Regarding Money Market Funds" (May 11, 2010),

7. In September 2008, the Treasury announced the establishment of a Temporary Guarantee Program for Money Market Mutual Funds to assist participating MMFs that broke the dollar to pay shareholders $1.00 per share upon liquidation. Under that program, MMFs were insured for up to $50 billion with assets from the Treasury's Exchange Stabilization Fund. The program expired in September 2009.

8. The Report states that capital redemptions from MMFs in the two days prior to the Treasury's Guarantee Program totaled about $200 billion, whereas in the two days after the program was announced outflows were only $22 billion.

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UK: PWG Issues Report on Money Market Fund Reform Options